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Marketing-services company R.H. Donnelley Corp. filed a consolidated income-tax return for the year ending December 31, 1994, on time. The Internal Revenue Service examined the return and determined that all was well; that is, the IRS did not determine any additional tax deficiencies prior to the expiration of the statute of limitations. As a result, Donnelley filed refund claims for its 1991 and 1992 tax years.

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The 1991 refund claim was based on unused research credits from the 1994 tax year that were carried back three years. The 1992 refund claim was based upon unused foreign tax credits from the 1994 tax year, also carried back.

The IRS sent Donnelley a “Statement of Income Tax Change” that noted a $43,727,655 “increase of tax” for 1994, based on a “total corrected income tax liability.” The IRS statement also noted that “this increase will not be assessed due to expired statutes of limitations for the 1994 tax year.”

But an IRS audit statement noted that, “due to a change in income in 1994, the proper credits are applied and used in 1994 against any tax that otherwise might have been assessed.” This left no credits to be carried back to 1991 or 1992. As a result, Donnelley would have been entitled to either nothing or $11,128,769, depending on the outcome of the lawsuit the company launched in a federal North Carolina district court. Unfortunately, the court chose the former alternative. (See R.H. Donnelley Corporation v. United States, _F.Supp.2d_ (E.D. N.C. 2010).)

“So while the IRS possessed no authority to collect additional taxes for 1994 in the Donnelley case, it is permitted to look at that tax year to determine whether carrybacks were proper for 1991 and 1992.” — Robert Willens

Computation vs. Determination Donnelley conceded that when a plaintiff sues for a refund in taxes paid, the government is permitted to conduct an audit to ensure a refund is owed. Donnelley argued that because this occurred after the statute of limitations had expired for the 1994 tax year, the government is only permitted to review its 1991 and 1992 tax returns, and must accept any carryback amounts from other years as they were stated when the statute of limitations expired. The court disagreed with this contention.

The court noted that “permitting the Service to review all relevant tax years is established in Hill v. Commissioner, 95 T.C. 437 (1990).” In Hill, the IRS determined a deficiency against the taxpayers on the basis that they were not entitled to a tax credit claimed in their 1982 tax year. The plaintiffs asserted that they were entitled to carry forward a credit that arose in the 1981 tax year. The statute of limitations had expired for the 1981 tax year.

Nevertheless, the IRS looked at the 1981 tax year and determined that the plaintiffs were not entitled to the carryforward because they did not report their entire rental income for 1981. The court found that because there was a deficiency for 1981, even though it could not be charged, the credits had to first be applied to that deficiency before the balance could be carried forward.

Therefore, the courts have distinguished between the IRS’s authority to compute a tax for a year that’s not at issue and its authority to determine a tax for such a year.

Indeed, in Lone Manor Farms v. Commissioner, 61 T.C. 436 (1974), the court held that the Internal Revenue Code does not prevent it from computing — as distinguished from determining — the correct tax liability for a year that is not being reviewed by the court when such a computation is necessary to a determination of the correct tax liability for a year that is at issue.

So while the IRS possessed no authority to collect additional taxes for 1994 in the Donnelley case, it is permitted to look at that tax year to determine whether carrybacks were proper for 1991 and 1992. The court cited the following passage from Lewis v. Reynolds, 284 US 281 (1932) in support of this proposition: “…although the statute of limitations may have barred the assessment and collection of any additional sums, it does not obliterate the right of the United States to retain payments already received when they do not exceed the amount which might have been properly assessed and demanded….”

The court further observed that in this case, the IRS is not seeking to recover additional taxes from Donnelley. Instead, it is using its “shield” to protect the government from having to issue an unearned tax refund. Thus, because Donnelley was found to have a deficit in taxes for 1994 that substantially exceeded the credits, the company cannot carry back those credits and, consequently, is not entitled to the tax refund it seeks.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.